Markets see the wind taken out of their sails

Markets have seen choppy waters in recent months, but four factors are positive for stocks, says strategist Peter van der Welle.

Peter

van der Welle

Strategist

Speed read

Stock markets likened to a ‘Chinese gybe’ where the boat keels over

Four factors remain positive, though no return to plain sailing in 2019

Robeco remains overweight equities but is becoming more defensive

He likens the stock market turmoil to a ‘Chinese gybe’ – the sudden keeling over of a boat into the windward direction, often as a result of changing windspeed. However, the investing ship can be righted due to a changing tide of Fed policy, declining political uncertainty, the global economy sitting at an inflection point, and lower equity market multiples, he says.

“It has been anything but plain sailing in financial markets lately. Despite corporate earnings growth powering ahead this year, risky assets have made little progress in the year to date, as investors have been confronted with a potent mix of headwinds,” says van der Welle, a strategist with Robeco Investment Solutions.

“These range from China-US trade skirmishes, negative economic growth surprises and the Fed progressing to a more neutral monetary policy, to the Italy-EU standoff about the Italian budget, the Brexit process entering a critical phase, and a sudden slump in oil prices adding to worries about slowing global aggregate demand.”

“As a result, returns in local currency for the global equity market in the year to date were a meagre 0.5% at the end of November. Adding to the complexities of the current investment climate, even the traditional safe-haven asset of gold, which is down by 7.2% in US dollar terms year to date, has failed to shine amidst the recent turbulence. The global monetary tide is going out, and real interest rates (the opportunity cost of holding gold) have increased, as excess liquidity is receding.”

Fed policy steadies the ship

Van der Welle says the pending question for investors is how this Chinese gybe in financial markets will be corrected. “Can investors eventually salvage their boats? There are a few hints that they indeed may be able to do so,” he says.

“First, recent comments by US Federal Reserve Chairman Jerome Powell that the central bank’s policy rate may be ‘just below’ the range of neutral rate projections by Fed board members could be read as an acknowledgement of being close to an inflection point.”

“However, investors need not fear inflection points, as a deceleration of growth is still a different beast compared to an outright contraction. This purportedly dovish shift in tone from the Fed does not exclude rate hikes in the future. At most, it signals a higher hurdle rate for a steady 25 basis point rate hike each quarter, as previous Fed hikes are starting to tame aggregate demand and core inflation.”

“Furthermore, the Fed has never ended a post-WWII tightening cycle without lifting the real policy rate to a level of 2%. This time may be different, but with current real policy rates in the US still stuck around the exceptionally low level of 0.25%, it is premature to think the Fed is done for this cycle. Future Fed rate hikes will likely exceed the pace currently priced in by the futures market, which is now a single 25 basis point rate rise for 2019.”

Worst may be over

Meanwhile, geopolitical and economic policy uncertainty could be peaking, with the worst behind us, Van der Welle says. “The US-China talks on the sidelines of the recent G20 summit may not have led to a grand bargain, but it has at least delivered a promising 90-day armistice in the trade war,” he says. “The Italian government has made the first conciliatory moves on the budget demands made by the European Commission, indicating it may revise its budget deficit to below 2% of GDP.

“A decline in economic policy uncertainty should require lower ex-ante risk premiums in financial markets, and could partly unlock some of the value created in the recent market rout. This could hold especially true for emerging market assets.”

“Sentiment has become bearish, with the US retail investor bull-bear indicator now in bearish territory. This has often provided a contrarian signal for markets.”

“Sentiment-depressing signals such as the recent inversion of the three-year to five-year US yield curve have to be taken seriously. But ‘bear’ in mind that historically, a recession has emerged on the scene with a significant lag (on average, of 17 months) after an outright inversion of the more important two-year to ten-year section of the yield curve – which hasn’t inverted yet.”

It’s not yet plain sailing

However, it’s not yet plain sailing, even though equities have become relatively cheaper. “Valuation levels are a bad timing instrument, but at the margin, the future return potential has improved, while stock derating has lowered the hurdle for a rebound in equities when growth surprises start to improve again and political risk recedes,” Van der Welle says.

“So, yes, investors will probably be able to salvage their boats from the Chinese gybe that hit them in 2018, but that doesn’t imply a return to plain sailing as we enter 2019. With global growth starting to decelerate, riding the wave of worry posed by lingering geopolitical risk, and a Fed that is not done for this tightening cycle, things remain challenging. At Robeco Investment Solutions, we remain overweight equities, but at the same time are steering towards an overall defensive stance within the equity space.”

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